Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Monday, May 20, 2013

Peek-ing Into "Rollover As Business Startup" IRAs

They are called ROBS – an acronym for “Rollovers as
Business Startups.” The idea is to own a business through your IRA. Perhaps your
IRA could be the bank in the transaction. Perhaps the business will go
exponential, which would do wonders for your IRA balance.

Me? I do not particularly care for them.

Why? This field is so fraught with landmines I
cannot help wonder why I would want to cross it. And like Al Pacino in
Godfather 3, “just when I thought I was out, they pull me back in.” “They”
would be a client whom we will call Jay. We were discussing a biomedical
startup on the east side of Cincinnati. High risk, high reward: that type of
thing. Should it hit he would be having breakfast on his yacht off the coast of
St. Augustine. Maybe I could visit.

“If it goes wrong,” said Jay, “I lose my investment.
There is still plenty of time for me to recover.”

In this case, Jay was right. Jay would not be
working at the business. He would not be renting property or equipment to the
business. He would be a passive investor, which reduces his tax risk
considerably.

But what if the business had to borrow money? What
do you think the odds are that a small business, with little or no track
record, would be able to borrow without the owner’s guarantee? Remember, Jay
(or rather, Jay’s IRA) would be an owner.

This is a trap. Let’s discuss how someone fell into
the trap.

In 2001, Lawrence Peek (Peek) and Darrell Fleck
(Fleck) decided to buy a fire protection company, Abbott Fire & Safety, Inc
(AFS). The brokerage firm facilitating the deal introduced them to Christian
Blees, a CPA. Mr. Blees presented a tax strategy, which he called “IACC.” IACC
involved establishing a self-directed IRA, transferring money into it from
another IRA or 401(k), setting up a new corporation and having the
self-directed IRA purchase shares in the new corporation.

In other words, a ROBS.

There is also something subtle here. Mr. Blees had
structured a tax strategy, and he sold the strategy to clients. What was his
role here? We will come back to this.

Anyway, reams of paperwork were exchanged and
signed, with all the waivers and exculpatories and whatnots. Peek and Fleck set
up their self directed IRAs. Each puts in $309,000 for a 50% share in a new
company (FP). FP in turn acquires Abbott (AFS).

Peek and Fleck were well advised. In 2003, they each
converted one-half of their IRA into a Roth. They each converted the remaining
half in 2004. Remember that there is no tax in the future when money comes out
of a Roth. FP is going to the stars, and Peek and Fleck are going to make a tax-free
bundle.

In 2006, they sell the company for approximately $1.7
million, to be collected over two years.

The IRS examines the 2006 and 2007 tax returns. The
IRS voids the IRAs. This means the IRS includes the gain from the sale of FP
stock on their personal returns. The IRS also assesses the substantial
understatement (20%) penalty. As backup bombardment, the IRS imposes excise
taxes for excess contributions to the IRAs.

What…?

Let’s walk through this.

An IRA is (generally) exempt from tax under Section
408(e)(1). A tax pro however will continue reading. A little further, Section
408(e)(2)(A) says that an account will cease to be an IRA if “the individual
for whose benefit any individual retirement account is established… engages in
any transaction prohibited by Section
4975.”

It behooves us to review Section 4975 and to stay as
far away from it as possible.

Let us look at this ticking bomb defining a
prohibited transaction:

4975(c)(1)(B)
(the) lending of money or other
extension of credit between a plan and a disqualified person

So what? There was a guarantee, not a loan, right?

However, a guarantee is considered an indirect
extension of credit (this is the Janpol case).

Peek and Fleck argued that the guarantee was between
them and FP, not between them and the IRAs.

The Court pointed out the obvious: FP was owned by the
IRAS, so - in the end – Peek and Fleck were transacting with their IRAs.

Oh,oh…a
prohibited transaction.

The Court noted that the guarantees existed without
interruption since 2001. This meant that the IRAs ceased to be IRAs in 2001,
when Peek and Fleck signed the guarantees. Yipes!

The Court now addressed the “substantial
underpayment” penalty. Peek and Fleck immediately defended themselves by
arguing that they had relied upon a CPA: Christian Blees. Reliance on a pro has
long been accepted as reasonable cause to sidestep the penalty.

Too bad, said the Court. Mr. Blees was not a disinterested
professional. He was selling a financial product. Heck, he had given it a name:
“IACC.” He was not functioning as an independent CPA in this matter. No, he was
functioningas a “promoter.” Reliance on
a promoter is not grounds for reasonable cause.

The Court affirmed the substantial understatement
penalty.

What about the Roth conversions in 2003 and 2004?
Each man would have paid tax upon conversion. Can they now get that money back?

The Court did not address this. Why? Remember that,
after three years, a tax year will close. This means that the IRS cannot amend
it. It also means that you cannot amend it. This case was decided in May 2013,
so unless Peek and Fleck did something special to keep the 2003 and 2004 years
open, there was no way to amend those years. They would simply have been out the
tax they paid.

(2)Did
rent payments by FP to a company owned by Mrs. Peek and Mrs. Fleck constitute
prohibited transactions?

(3)Did
Peek and Fleck put too much money into their (Roth) IRAs, thereby triggering
the excise tax for excess contributions?

The
Court reviewed the wasteland after the nuclear blast of retroactively
disqualifying the IRAs and decided that it did not need to consider these
issues. Perhaps it felt the bodies were sufficiently dead.

As
I said, I do not especially care for ROBS. They can detonate in a hundred
different ways. Today we talked about just one of them.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.